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14.127 Behavioral Economics. Lecture 12
Xavier Gabaix
April 29, 2004
0.1 Twin stocks
• Shell and Royal Dutch–claims on the same company
• There is a difference between prices
• The difference is driven by the difference in aggrogate movements in London
vs Dutch stock markets
• Sharpe ratio (expected return/standard deviation) of this aribtrage is not
0.2 Are noise traders eliminated from the market?
• Might be both positive and negative
• If γ is large enough, then E (RNT − RA) > 0 and noise traders prevail
• This is because noise traders are more optimistic and take more risk
• But by construction EUA > EUNT
• Stock returns look like a random walk [see slides]
• Evidence from stock splits – supports efficient market hypothesis [see
• Event study methodology [see slides]
• Jensen: “The Efficient Market Hypothesis is the best established fact in all
of social sciences”
• de Bondt and Thaler JoF 1985 [see slides]
• Value vs growth [see slides]: a recent attempt at explanation by consumption
covariance – growth stocks have low covariance with consumption
because most of risk is idiosyncratic; conversely GM has high covariance
(Parker, Julliard, Barsal)
• Initial Public Offerings [see slides]
0.3 Campbell-Cochrane “By force of habit” JPE 1999
• Explains low equity premium in booms and high in recessions
where Xt is your habit
surplus/consumption ratio, st = ln St < 0.
• “Catching up with the Joneses economy” – what makes me happy is not
my consumption compared to my past consumption (internal habit) but
my consumption compared to past consumption in the economy (external
• This is too simplify the problem: noone’s current consumption impacts his
or her future habit
• Representative consumer economy. Aggregate
• Postulates
where g is mean growth rate and φ ∈ (0, 1) determines mean reversion.
• Lucas economy
• Euler equation
• They postulate 1 +r = E [Mt+1] is constant
• Hence
• To price stocks, use
to write the Euler equation as
• Thus
• Postulate,
and solve for f (st).